Trend Methods 

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Trend Methods

Some technical analysts believe that it is important to identify a trend that is more likely to persevere over a period of time. In other words, once a trend has been identified, you should move with it:

In an up market, you should be buying, and in a down market, you should be selling, until the trend is broken.

Table 11-3
Relative Strength Ratio Between Stock X and Stock Y

Relative Strength Ratio Between Stock X and Stock Y

Moving Average

The moving average includes the most recent price and eliminates the earliest price from the figures in the distribution before computing the average. The moving average is one of the more popular methods for determining a trend. An average is the sum of a collection of figures divided by the number of figures used in the numerator; a moving average is an average over time. Table 11–4 illustrates the computation of an average for a stock using for a 10-day period.

A10-day moving average adds the stock price for the eleventh day and drops the stock price for the first day. For instance, if the closing price on the eleventh day is $18 per share, the new 10-day moving average will be

10-day moving average = (10-day average + eleventh-day price – first day’s price)/10
= (165 + 18 –15 3/4)/10 = $16.725

By continuing this method of adding the next day’s price and dropping the oldest day’s price, the moving average is calculated over time. You can plot this moving average to show the graphic trend over time and show how the moving average compares with daily stock prices. When the moving-average line crosses the line of actual prices, this indicates a change in trend. The moving-average line tends to smooth out any volatility in actual daily stock prices. You can choose any length of time for a moving average: 10, 15, 30, or 200 days, for example. The 200-day moving average is frequently used, but calculating 200 days of stock prices can be tedious, particularly if you are interested in a large number of stocks.

Table 11-4 Moving Average
Moving Average

The length of time chosen for the moving average has an effect on the trend line. Ashorter-duration moving average results in greater sensitivity to price changes than a longer-duration moving average. With the former, an investor who religiously follows the signals given with the frequent crossing of the trend line and the price line will be encouraged to trade stocks after small changes in price, as illustrated in Figure 11–9. Technical analysts pay particular attention to the crossovers of the price line with the moving average, which indicates a buy or sell signal. The crossing and rising of the price line above the moving-average line indicates a buy signal. The opposite situation occurs when the moving average crosses and rises above the price line, which indicates a sell signal. Ashorter-duration moving average encourages frequent trading with a volatile stock price, which results in both greater transaction costs and capital gains taxes paid, thereby reducing or eliminating any profits. With a longer moving average, the trend line exhibits a greater lag behind the actual price line of these stocks. Technicians use the moving average of the DJIA to determine the trend for the market.

Figure 11-9
Buy and Sell Signals Using a Stock’s Price and Moving Average

Buy and Sell Signals Using a Stock’s Price and Moving Average

A study done by James C. Van Horne and G. G. C. Parker (1967) suggests that use of the moving average as a tool for buying and selling stocks does not produce superior results. Another study done by James (1968, pp. 315–326) indicates that buying and selling strategies based on moving averages produced lower returns than a buy and hold strategy.

The fact that investors need to decide on the time period to use for the moving average and whether they should buy or sell when the lines cross suggests a somewhat arbitrary and simplistic approach to the complexities of buying and selling stocks. If a major upward trend in a stock takes place, an investor profits from it by buying early. Of course, the opposite is also true. If an investor recognizes a major downward trend early and sells before the stock decreases in price, that investor is ahead of the game. However, for stocks that exhibit volatility, this method may give equivocal signs and encourage frequent trading, which is costly when transaction costs are involved.

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